With the growing momentum towards low-cost index funds and ETFs (exchange traded funds) which have $5 trillion and growing, investors and plan sponsors may be overlooking the hidden dangers according to an article in Kiplinger. With low fees and predictable performance, what can go wrong?
Over a 10 year period starting 2006, 82% of large cap funds under-performed the S&P 500 while 88% of funds investing in the stocks small and mid-sized fared even worse. Hedge funds are not immune: Warning that large pension funds are burning through capital, Warren Buffet bet that a Vanguard S&P 500 index fund would outperform a basket of hedge funds selected by a consultant from 2008 through 2017. So far the results are stunning. Hedge funds selected by the consultant returned 21.9% while the index fund rose 65.7% over the same period.
So what are the dangers of index funds or passive investments?
- Trading Costs – Indexes are constantly changing the underlying stocks that make up their formula so trades must be made to keep up which can be expensive.
- Buy High – When a new stock becomes part of an index, their price usually soars which means index funds buy high.
- Obscure Indexes – They have become so popular that some indices are hard to figure or become more like active funds like the one that follows stock that benefit from the rising spending power of Millennials like Amazon and LinkedIn.
- Switching Indices – Passive funds can switch the index they follow which, though disclsosed, can be hard to follow.
- Bubbles – Indexes do poorly in a bubble as market weighted indices by their nature follow hot stocks. For example, tech stocks made up 30% of the S&P 500 in 1999 and 14% in 2002 after the 2001 tech bubble.
So what’s the right solution? Kiplinger recommends a mix of index funds while other experts advice a mix of passive and active investments which is the course followed recently by American Airlines which revamped their menu after the merger with US Airways.
